In the March 13, 2012 Ask The Headhunter Newsletter, the owner of a start-up business asks whether it’s smart to give equity to a new hire:
After years of frustration with the way many professional services firms treat their clients, I decided to launch my own business. I have had modest success in my first six months and I am considering adding an employee. The individual that I am interested in has expressed concern about the added risk of working for a small company. He wants me to give him an equity stake to offset the risk, but I don’t want to give away too much too early, considering the competitive nature of the marketplace and my own business vision. What would you recommend?
Here’s the short version of my advice:
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There are two kinds of people in your start-up world, other than clients: employees and investors. You can’t fill a job with an investor. You must fill it with an employee.
Now, I’m a big believer in sharing profits with good employees. And I think it’s a great idea to make employees owners to a reasonable extent, commensurate with their commitment to the business. That’s what profit-sharing plans are about.
But employees must earn their way into ownership of the business. It’s simply not good management practice to give away ownership of your company before you know what you’re getting in return. If this individual were bringing you new clients or some kind of intellectual property to enhance the value of your company, then and only then would I consider giving him equity from the outset.
If you hire an employee whose contributions become a true investment and a key part of your business, then at some point sharing some equity may be a key to your long-term success.
You can test this candidate’s motivations. Try this:
How to Say It
…(Sorry, this part is only in the newsletter… Don’t miss next week’s edition. Sign up now. It’s free!)…
…This person is clearly looking for security and potential riches without making a solid investment.
I’d find another candidate, or someone who wants to invest in your business as a partner. Take a look around: Even jobs with big, stable companies are risky. There is no such thing as job security.
In the future, I would look for candidates who want to add value to your business and to make you more successful — not ones that want you to protect them from risk. Talk about jobs and salary to potential employees. Talk about investment and risk to investors. But don’t confuse the two.
Does your company offer equity to new hires? Have you ever accepted equity to join a start-up? How did it work out? I’d like to hear what you have to say about the risks of start-ups — and the joys of taking risks!
I have a small amount of equity in our architecture/engineering consulting firm. How we do it is offer the option to buy equity after, say 6 months or a year, if things go well and as expected. At the end of that “probation” period, then either party can back away from the deal.
The startup world has solved this with stock options that vest over time. The first year has what’s referred to as a “cliff,” meaning no vesting happens until exactly a year has passed. Then the remaining options vest incrementally each month.
Side note: “this part is only in the newsletter” is an obnoxious way to drive signups. I say this as someone who gets the newsletter already. This is 2012, not 1995.
I think that it is 100% reasonable and legitimate for job seekers to consider job security as one of their factors in selecting an employer. For employers with low job security, the employee has legitimate bargaining power to ask for something else in return (maybe higher pay, greater flexibility, more vacation…or even equity).
It’s not as if all employers offer the same level of job security. Some employers (Nucor, Vanguard, Lincoln Electric, Southwest Airlines, FedEx, Toyota) pride themselves on never having laid anyone off before, and I think they can and do get away with paying their people slightly less in exchange for the higher job security. Sure, a no-layoff policy is not a guarantee of a job in perpetuity, but if you’re going to play the odds and you’re concerned about job security, it would be silly not to acknowledge that there are meaningful differences between firms in this regard.
I’m from the hi-tech world renowned for it’s start ups. In most cases the game plan is eventually to go public..so it’s common practice to offer a “sweat equity” compensation. That is it’s understood you trade off pay (think slave wages/or being underpaid) for stock options. That’s how you deal with risk. Risk is inherent. it’s a start up. If it flies, it’s big time payback, options cashed in plus adjustment in wages, benefits etc. and if you wore yourself out, you call in rich. If it bombs…well everyone knew the risks up front.
The scenario posed doesn’t sound like a “go public route” but private & I think you’re on target. You earn you’re way to equity. In the interim, come up with pay plus a profit sharing kicker. Assuming success, if the newbie adds value the profit will be there to share. If not, equity is moot. If profit sharing still isn’t sufficient, then they can talk equity, but in so doing, the person having real experience and track record to assess risk should be asked to invest for the equity. Because, The risk door swings two ways, the employer also takes it when hiring the newbie, and not just on performance, now on business compatibility and management. How many horror stories have you heard about business partnerships imploding due to head butting? Skin in the game at least gives partners food for thought and an incentive to get along. Then what? equity for every additional addition?
Usually equity is given to early employees when they invest in the company by taking a lower salary. Equity to compensate for risk is absurd. If the risky job doesn’t pan out the company will be out of business and there won’t be any equity.
Typical equity calculation: Figure out what percentage of the company you would sell to an investor for $100k today. If the employee agrees to accept $100k less than market-rate salary for the first year then the employee will get that much equity at the end of the first year of employment. Usually you’d calculate and award it every month. You would never award equity at hire time.
It seems to me that Nick is right and both you and the employee are better served by a profit-sharing plan. That way you will not be mixing up the employee/investor/co-owner roles which would make your life much harder. The employee would have a much simpler payment and tax situation. At your small size, you’d probably have an open books policy so the employee would be able to trust you not to finagle the profit-sharing calculation.
If the prospective employee is caught up in the current Silicon Valley internet bubble where naive young men work 24-7 for peanuts in exchange for promises of equity that will never put a dime in their pockets (but they’re so sure they’ll be the next Zuckerberg!) then you’ll never reach an agreement and you should look for someone else.
Not sure I agree with Nick’s perspective to your question, but bottome line, a privately- held start up firm with only one other employee (which it sounds as if this is the case) should not use equity to attract a new employee. An important point to consider as to whether equity would be appropriate in the future, what expectations do you have? Is this person going to grow revenue? provide you with a service capability that you are confident that you can sell? The person’s role and the impact on your business plan of his/her executing that role well should impact your decision of whether to offer equity as part of a compensation package. As has been noted by someone else, offering equity will not reduce the candidate’s risk.
Assuming you decide it is not worth offering equity at this time, others have already made some suggestions as to what other alternatives are available to attract and retain the candidate. Having worked with many companies like yours, there is no way I would join the firm based on profit sharing (revenue sharing or margin sharing, yes). With small business owners, I have found them very reluctant to reveal how profits are determined.
I really do not like your testing a prospective employee by asking, “Forget about the job. Maybe you’d just like to make an investment in the company.”
First, what if they do not have money to invest in the company? The employer does not know the candidate’s financial situation nor their investment practices. This question could very easily put the candidate in a corner or make them wonder if this is not an actual job interview by a pitch to invest.
Second, the prospect would be investing them self into an unproven 1-person company by accepting the position. It is likely they are taking a risk by leaving another company to take a chance on your startup, which could succeed or totally fail.
I agree that a new employee should be given equity IFF they show their worth six-12 months down the road.
I thought Nick’s question there was really wise for two reasons … #1) The job seeker is asking for an equity partnership very early in the relationship, which it sounds like for this person’s industry/business is a little bit pushy. What Nick is suggesting is that the owner push back a little and #2) See what the candidate says/how they respond.
(Nick often seems to encourage getting more information … usually by asking! It’s such a clean, simple way to proceed. And often so very effective.)
I’d like to second what Don and G wrote. I have started, bought and sold a few small firms (15 – 100 employees). We did not operate on the Silicon Valley model. Trading equity for risk is fine, but if the employee is expecting at or near market rates for their work, then equity is the wrong incentive. If they’re willing to work for rates substantially below market, then it’s worth discussing.
For what it’s worth, when I started my first firm (professional services firm) and was recruiting a team I offered a couple of candidates equity. Neither accepted the offer, and in the end I’m very happy it worked out that way. I was taking the risk; I signed the personal guarantees on the company’s credit line; 100% of my pay was on the line. Until a candidate is ready to offer the same (or near the same) then I say keep your equity for yourself.
@G: “If the risky job doesn’t pan out the company will be out of business and there won’t be any equity.”
I thought it would take longer for someone to point that out. Score 10 points! You can’t use equity as protection against risk. It’s a goofy idea.
@dacker: You say my question about making an investment instead of taking a job is unfair. I half agree, because I meant it a bit tongue in cheek. But Arlington gets my point: I’d ask the question with a smile and make it a bit of a friendly challenge. My larger point: Don’t confuse investment with salary.
When start-ups offer stock as part of a comp package, my advice is the same whether the start-up has decent prospects or great ones: Take the job only if the salary is enough. Put no value on closely-held stock. If it pays off, consider it a bonus.
If you’re a founder of the company, everything changes, of course. Note what Will said: “I signed the personal guarantees”
I’d never give equity in my start-up to anyone who didn’t sign the personal guarantees. You want in? You take a risk. Equity cannot be denominated as salary.
@K: “‘this part is only in the newsletter’ is an obnoxious way to drive signups.”
Suggest a better way to do it. The newsletter and blog are both free.
I subscribe to the newsletter too and always hate seeing that phrase on your blog posts. Partly it’s that I usually see the blog post first, read it here, then see that I will have to read it a second time when I get the email in order to get the full answer. No offense, but it’s annoying to have to read something twice in two different places to get the full answer.
You drive email sign-ups by offering something that people want. In this case, it would probably be getting columns emailed to them, which is a convenience some people like especially if they don’t use RSS or other means of seeing when you have a new blog post. But I agree that the current system is annoying.
@Eliza: Thanks for commenting on “subscribe to get the whole thing.” You guys have got me thinking about this now. It raises a good question that I don’t have an answer to: Are there any folks who read the blog who don’t subscribe to the newsletter? How many? Because I do all this for free, it’s hard to take the time to run the metrics… Ideas?
We would all like to work for the next Facebook or Google, but the reality is you may do better with lottery tickets. I worked for 4 startups in a row and neither panned out to become anything. My experience with one that went thru IPO was as a condition of being funded was the options went to reverse split, there was a lockup period where current employees could not exercise their options to 6 months after IPO. The only ones that did were the founders who resigned before the IPO who cashed out. after the lockup period my options were under water. My suggestion is look at other job opportunities and disregard any value that options have.
Interesting article Nick, and gives me food for thought. Since I don’t have a magic ball, it is hard to predict which start-up companies will be successful and which will go belly-up. Every company that exists today was at one time a start up. I think it’s a crapshoot–if you’re so inclined and don’t mind the squirreliness of start-ups, then by all means work for one or invest in one. Any number of factors can contribute to its success or failure, including factors such as a bad economy, war, happening to create/promote/develop the next new thing that no one can control.
As per the issue, I see it as are you an owner (because you’ve ponied up some money to invest in the company) or are you an employee? In my second-to-last job, the company offered profit-sharing to its employees as one of its benefits. If we had a good year, then all of the EMPLOYEES got an extra check based upon how well the company, and some depts. got more in those checks because they had a greater role in that success. I see employees as the ones who work for the company, owners invest in it, although in some companies (such as mom-and-pops) they too might be employees in that they also work there (often to avoid having to hire and pay someone else and thus save money). But I don’t see equity equaling salary.
And if the company goes belly up, there won’t be salaries for workers because they’ll be out of work nor any return on the investment made by the owners (because that’s a risk you take when you invest in ANY company).
Nick, dear Nick, I didn’t take any offense at your “subscribe to get the whole thing”. I found your newsletter in “What Color is Your Parachute?” You and your newsletter (complete with URL) were listed in a section about where career and job seekers could find more excellent advice from experts. I can also imagine someone who is searching the internet, using keywords, and stumbles upon your website. He finds it, is interested, and your statement tells him that he needs to subscribe in order to get the whole newsletter. It doesn’t bother me that you have this statement–you’re not creating two newsletters–one for subscribers and one for those who find you through WCIYP or who happen to find you on the internet but haven’t subscribed yet. No harm, no foul.
I’ve no idea how you could find out who or how many people read your blog without subscribing. And since your newsletter is free, that’s another reason not to take offense at the statement.
The only glitch is that occasionally I haven’t received my weekly fix–the first time that happened was a couple of months after I’d originally signed up, and I figured it was some weird email thing, so I re-subscribed. There was the recent delivery glitch–got the blog but couldn’t access the full letter/answer, then you corrected it the following week (thanks!). Now I get both–but I can usually tell by looking at my inbox which is the full newsletter and which is the condensed version. I figured it is a tech glitch of some kind, and I’d rather get both than get none of the one that I can’t see the full answer.
Thanks again Nick, and keep up the good work. Your letters are informative and helpful–I hope I can put your advice to use soon.